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The Elliott Wave Principle
In the 1930s, Ralph Nelson Elliott,
a corporate accountant by profession, studied price movements in the
financial markets and observed that certain patterns repeat themselves.
He offered proof of his discovery by making astonishingly accurate stock
market forecasts. What appears random and unrelated, Elliott said, will
actually trace out a recognizable pattern once you learn what to look
for. Elliott called his discovery "The Elliott Wave Principle," and its
implications were huge. He had identified the common link that drives
the trends in human affairs, from financial markets to fashion, from
politics to popular culture.
Robert Prechter, Jr., president of Elliott Wave International,
resurrected the Wave Principle from near obscurity in 1976 when he
discovered the complete body of R.N. Elliott's work in the New York
Library. Robert Prechter, Jr. and A.J. Frost published Elliott Wave
Principle in 1978. The book received enthusiastic reviews and became a
Wall Street bestseller. In Elliott Wave Principle, Prechter and Frost's
forecast called for a roaring bull market in the 1980s, to be followed
by a record bear market. Needless to say, knowledge of the Wave
Principle among private and professional investors grew dramatically in
the 1980s.
When investors and traders first discover the Elliott Wave Principle, there are several reactions:
* Disbelief – that markets are patterned and largely predictable by technical analysis alone
* Joyous “irrational exuberance” – at having found a “crystal ball” to foretell the future
* And finally the correct, and useful response – “Wow, here is a valuable new tool I should learn to use.”
Just
like any system or structure found in nature, the closer you look at
wave patterns, the more structured complexity you see. It is structured,
because nature’s patterns build on themselves, creating similar forms
at progressively larger sizes. You can see these fractal patterns in
botany, geography, physiology, and the things humans create, like roads,
residential subdivisions… and – as recent discoveries have confirmed –
in market prices.
Natural
systems, including Elliott wave patterns in market charts, “grow”
through time, and their forms are defined by interruptions to that
growth.
Here's
what is meant by that. When your hands formed in the womb, they first
looked like round paddles growing equally in all directions. Then, in
the places between your fingers, cells ceased growing or died, and
growth was directed to the five digits. This structured progress and
regress is essential to all forms of growth. That this “punctuated
growth” appears in market data is only natural – as Robert Prechter,
Jr., the world's foremost Elliott wave expert and president of Elliott
Wave International, says, “Everything that thrives must have setbacks.”
Basic
Elliott Wave PatternThe first step in Elliott wave analysis is
identifying patterns in market prices. At their core, wave patterns are
simple; there are only two of them: “impulse waves,” and “corrective
waves.”
Impulse
waves are composed of five sub-waves and move in the same direction as
the trend of the next larger size (labeled as 1, 2, 3, 4, 5). Impulse
waves are called so because they powerfully impel the market.
A
corrective wave follows, composed of three sub-waves, and it moves
against the trend of the next larger size (labeled as a, b, c).
Corrective waves accomplish only a partial retracement, or "correction,"
of the progress achieved by any preceding impulse wave.
As
the figure to the right shows, one complete Elliott wave consists of
eight waves and two phases: five-wave impulse phase, whose sub-waves are
denoted by numbers, and the three-wave corrective phase, whose
sub-waves are denoted by letters.
What
R.N. Elliott set out to describe using the Elliott Wave Principle was
how the market actually behaves. There are a number of specific
variations on the underlying theme, which Elliott meticulously described
and illustrated. He also noted the important fact that each pattern has
identifiable requirements as well as tendencies. From these
observations, he was able to formulate numerous rules and guidelines for
proper wave identification. A thorough knowledge of such details is
necessary to understand what the markets can do, and at least as
important, what it does not do.
You
have only just begun to learn the power and complexity of the Elliott
Wave Principle. So, don't let your Elliott wave education end here. Join
Elliott Wave International's free Club EWI and access the Basic Tutorial: 10 lessons on The Elliott Wave Principle and learn how to use this valuable tool in your own trading and investing.
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